Portfolio Rebalancing 101
Today we will explore what portfolio rebalancing is and why it matters in your financial life.
What is portfolio rebalancing?
Once a portfolio is invested, some assets will grow faster than others over time. This will naturally create drift away from the intended asset/security mix within a portfolio. Rebalancing refers to making trades to move a portfolio back to its intended weights, both at an asset class level (i.e. the target % mix of stocks and bonds) and at the security level (i.e. move back to the intended target weights for individual securities held within an asset class).
Examples
Asset Level – At the start of the year a sample portfolio contains 50% stocks and 50% bonds – the targeted asset allocation mix set for the portfolio. After one year, stocks return 10% while bonds return 2%. The new asset allocation mix would be 52% stocks and 48% bonds. Trading is conducted to move the weights back to 50%-50%. Stocks are sold and bonds are bought to achieve this.
Individual Security Level – Rebalancing back to intended target weights results in selling a portion of the individual stock/bond positions that have appreciated the most to fund purchases in positions that have appreciated the least or declined.
Why is rebalancing important?
Rebalancing serves a few key functions.
1 – It places the portfolio back in alignment with the intended composition, which should match an investor’s preferences, return objective, and willingness and ability to bear risk. If a portfolio is not rebalanced, returns could dictate that the portfolio becomes out of alignment with investor goals and risk tolerance, which could lead to inappropriate levels of risk-taking relative to targeted return.
2 – The oldest and perhaps best-known adage of finance is “buy low, sell high.” Rebalancing helps investors heed this advice. It naturally enforces discipline that capitalizes on a core tendency of markets, mean reversion (when prices extend far below or above trend, they tend to revert back toward the long-term average or trend). You sell high (positions or asset classes that have appreciated) to buy low (positions or asset classes that have not appreciated as much or declined). While rebalancing may not be beneficial in every instance, over a longer time horizon, consistent rebalancing has been shown to improve returns relative to risk.
3 – Rebalancing also helps mitigate some common behavioral finance pitfalls that impact investors such as endowment bias (assign a greater value to an asset because you already own it), herding (following the crowd and current momentum), and recency (the expectation that more recent events, such as prevailing market trends, are likely to continue). Investors generally want to hold on to winners and sell losers, which is often a suboptimal approach in the long run. The discipline imposed by rebalancing helps correct for these biases.
What are the downsides to rebalancing?
There are three primary negative considerations associated with rebalancing.
1 – Trading costs
Even in today’s world where costs are substantially lower than prior history, there is still a price to conduct trading. Those costs may be direct (commissions, regulatory and exchange fees, transfer and clearing fees) or indirect (the impact a trade makes on the market price, bid-ask spread – the difference between highest offered price to buy and lowest offered price to sell a security). Given the cost of trading, it is advisable that rebalancing should not occur too frequently.
2 – Taxes
For investors with taxable accounts, the tax implications of rebalancing should be considered. Given that rebalancing typically involves selling assets that have appreciated to fund the purchase of assets with lesser performance, capital gains are usually created.
3 – Trending markets
Inherently, rebalancing has a contrarian impact on a portfolio’s positioning. In selling winners and buying losers during rebalancing, the portfolio is betting against recent market momentum. While studies have shown this approach may offer better risk-adjusted returns, in long-running bull markets the momentum advantage gained by a buy-and-hold approach may produce higher returns than a rebalancing approach (if the winners continue their outperformance).
What are some different approaches to rebalancing?
There are a few common approaches to portfolio rebalancing.
1 – Calendar-based rebalancing
With this approach, a portfolio is reviewed and changes are implemented at a set interval, typically quarterly or annually.
Pros – Simple and predictable. Limited ongoing monitoring between review dates needed.
Cons – May drive unnecessary trading if markets are flat. Could allow for wide drift from intended weightings between rebalancing dates, particularly if returns are volatile. Action timing is arbitrary, driven by the calendar, not the market.
2 – Threshold-based rebalancing (also called percentage-of-portfolio rebalancing)
With this approach, a threshold is designated which triggers rebalancing trading activity. For example, let’s say an investor’s target asset allocation is 60% stocks, 40% bonds. A threshold could be set at +/- 10% threshold to trigger trading. So, if stocks rise above 70% or fall below 50% of portfolio weight, then trading would be conducted to move the portfolio back to the intended allocation % mix.
Pros – More responsive to market movements vs. the calendar approach. Limits unnecessary trading. Keeps a portfolio tighter to the intended composition as it more quickly adjusts to big market moves.
Cons – Higher touch implementation and oversight (needs frequent monitoring). May drive excess trading in periods of high volatility if the threshold is set too narrow.
In real world applications, calendar and threshold rebalancing can be combined in a hybrid approach.
3 – Cash flow-based rebalancing
This approach uses dividends, interest received, or deposits to purchase underweight assets and positions while withdrawals are funded from overweight assets and positions in the portfolio.
Pro – Offers the potential for tax efficiency (does not expressly focus on selling winners like the other approaches do).
Con – The funds generated from dividends, interest, and deposits may not be large enough to move the portfolio back to the intended weights in periods of high volatility where weightings have moved materially. May result in persistent deviation from the intended composition if market moves are large and this approach is not supplemented with one of the other rebalancing techniques.
4 – No rebalancing (also called buy-and-hold)
With a buy-and-hold approach, investors do not undertake rebalance trading and the portfolio is allowed to drift.
Pros – Simple. Limited monitoring required. Limits trading costs and taxes. May benefit in momentum markets.
Cons – Portfolio can drift too far from stated goals and risk tolerance. The portfolio may become too concentrated and/or risky over time as risky assets have higher expected returns, but also carry greater volatility and risk of drawdowns.
What is Howe & Rusling’s approach to rebalancing?
At Howe & Rusling, we take a fiduciary responsibility to guide our clients with a long-term focus. As such, we believe in the benefits of rebalancing and apply several rebalancing approaches in practice. We manage a number of different investment strategies on behalf of clients that range from individual securities (stocks, bonds) to ETFs. We also manage some portfolios with a qualitative approach (subjective, industry and company research-based) and others with a more quantitative approach (rules-based, data-driven).
While the exact approach varies depending on the client and investment strategy, we use the principles of calendar-based rebalancing, threshold-based rebalancing, and cash flow-based rebalancing; all of which is overseen by our Wealth Management team, with assistance from the Operations and Investment teams. We believe using one or more of the rebalancing approaches may assist in helping meet client objectives within the context of their individual constraints and preferences.
Disclosures: This material is provided for informational and educational purposes only and should not be construed as investment, legal, tax, or accounting advice. The information presented is general in nature and may not be applicable to all investors or situations. The investment strategies and portfolio management practices described herein are general in nature and may not be appropriate for all investors. Actual portfolio management decisions, including rebalancing activity, will vary based on a client’s individual objectives, risk tolerance, tax circumstances, investment restrictions, liquidity needs, and other relevant factors. Not all clients will be invested in the same strategies or experience the same results. Portfolio rebalancing does not guarantee a profit, protect against loss, or ensure that an investor’s objectives will be achieved. All investing involves risk, including the possible loss of principal. Past performance is not indicative of future results. Examples contained herein are hypothetical and are provided for illustrative purposes only. They are not intended to represent the performance of any specific investment, account, or strategy and do not reflect the impact of fees, expenses, or taxes. References to market behavior, risk management, diversification, asset allocation, rebalancing, or investment strategies are provided for educational discussion only and should not be interpreted as recommendations to buy, sell, or hold any security or investment strategy. There is no assurance that any investment strategy will be successful. Tax considerations discussed are general in nature. Investors should consult their tax advisor regarding their individual circumstances before implementing any tax-related strategy. Howe & Rusling, Inc. is an SEC-registered investment adviser. Registration with the SEC does not imply a certain level of skill or training. Additional information about Howe & Rusling, including its Form ADV Part 2A, is available upon request or at www.adviserinfo.sec.gov.
